DALLAS - The near-failure by U.S. states to fund rising retiree health-care costs for millions of government workers threatens to produce budget crises similar to the one that pushed Stockton, Calif., to take a step toward bankruptcy last week.

States haven’t financed almost 96 percent of the $627.4 billion they were projected to owe for future retiree benefits in 2010, according to Bloomberg Rankings data. The estimated deficit grew from about 95 percent in 2009 as governors coped with lower general-fund revenue and rising demand for services following the longest recession since the Great Depression.

“The whole country is dealing with” finding a way to finance the projected costs of retiree health care, said Chris Christie, New Jersey’s Republican governor. His state owed almost $7,600 per resident for public workers’ post-employment benefits other than pension payments. Alaska, Connecticut and New Jersey had the largest unfunded liabilities, ranked in proportion to population, among the 47 states examined.

“How do we deal with the cost of health care, especially the cost of health care as we get older?” Christie, 49, told reporters March 1. The first-term governor pushed for measures enacted last year that increased pension and health-care contribution rates for government workers and raised the age for retirement with full benefits to 65 from 62. The changes are forecast to cut costs by at least $10 billion over 30 years.

Widening Gap

Delays in containing such expenses just widen the funding gap, said Glen Volk, an actuary for Itasca, Illinois-based Gallagher Benefit Services Inc., a consulting firm. States also may face higher borrowing costs as well as more pressure to cut services to pay for promised retiree benefits, he said.

Most states cover such expenses on a pay-as-you-go basis, yet per capita U.S. health-care spending rising an average 5.8 percent annually for the 10 years through 2009 has made covering required payments increasingly difficult. Stockton, confronting a $417 million unfunded liability for retiree medical benefits, took a step toward Chapter 9 bankruptcy Feb. 29 when the City Council voted to enter a 60-day mediation with creditors.

“There’s a point at which it becomes a problem,” Volk said. He has helped municipal governments forecast retiree health-care liabilities.

Bankruptcy Lever

Cities including Central Falls, Rhode Island, and Vallejo, California, have used bankruptcy to cut promised benefits to current and retired workers. States can’t seek court protection under the code’s Chapter 9.

In Alaska, where Standard & Poor’s said the unfunded liability for state retiree health care fell 47 percent in 2011, most of the reduction came from raised expectations of returns on assets in a trust fund set up to cover the costs, according to Gabriel Petek, an analyst in San Francisco.

“Most governments haven’t been funding it, but Alaska has been,” he said. He said part of the savings stemmed from rollbacks in benefits, though the bulk came from changed assumptions on trust investments.

Idaho cut benefit costs by pushing more retirees into Medicare, the federal health insurance plan for those 65 and older, according to David Hitchcock, an S&P analyst in New York.

“The low-hanging fruit is to just push people on Medicare,” Hitchcock said. “States are coming to the realization that that is the easy way to cut OPEB costs,” he said, referring to other post-employment benefits, such as health care.

Unprepared States

At least 20 governors and legislatures have failed to prepare ways to meet their projected expenses, said Sujit CanagaRetna, a senior analyst in Atlanta with the Council of State Governments.

The inaction paired with climbing health-care costs may create fiscal crises in states as the number of retirees rises, said Girard Miller, a senior strategist at Philadelphia-based PFM Group, which advises municipalities on financial matters. The liability “is like a sleeping cancer,” he said.

The gap may become starker as the U.S. population grays. The number of Americans eligible for Medicare is projected to rise 70 percent to 78 million in the 20 years to 2030, the Henry J. Kaiser Family Foundation said in a 2008 study.

Municipal and state governments have expanded their payrolls in the meantime, with cities, towns, counties and school districts employing 14.1 million in January, up 3.5 percent from January 2002, according to U.S. Labor Department data. State employment has grown 1 percent to 5.05 million in the same period.

Rocky Recovery

States still reeling from the recession “face a long and uncertain recovery,” according to analysts at the Center on Budget and Policy Priorities in Washington. In a Feb. 27 update, the nonprofit organization’s analysts said states had projected or closed $47 billion in deficits for the fiscal year that begins in July. Tight budgets make it harder to deal with future health-care costs.

Pennsylvania’s growing pension and benefit liabilities pose a risk that “will materially challenge” the state’s attempts to balance its budget, Moody’s Investors Service said in a December report. Pennsylvania ranked 24th in the Bloomberg Rankings analysis of unfunded liabilities for retiree benefits.

“We’re still where we were five years ago,” PFM’s Miller said. “If we continue on, it will cause budget problems. It’s going to squeeze out jobs and pay raises.”

Affecting Ratings

Since state and local governments began disclosing the projected costs of promised retirement benefits about five years ago, bond analysts have begun weighing the obligations when they grade government debt.

Connecticut’s “fixed costs for debt, pension, and other post-employment benefits (OPEB) relative to budget are among the highest in the nation” and remain a fiscal challenge, Moody’s analysts said in a January report. Taken together, “they will continue to consume an increasingly larger portion of the state’s budget,” absent further changes, the analysts said.

“Rating agencies are forcing states that ignore it to expect their credit ratings to be impacted,” said CanagaRetna. “States are looking to catch up.”

Moody’s cut Connecticut’s $14.6 billion of general- obligation debt one step to Aa3, its fourth-highest grade in January. It gave the state a “stable” outlook, citing steps taken last year to curb pension and benefits liabilities.

More Urgent Needs

States have been slow in tackling the retiree health-care cost issue to avoid pressure for benefit cuts or funding increases, which may divert money from other priorities, said David Crane, who was an adviser to former California Governor Arnold Schwarzenegger, a Republican. Schwarzenegger’s final budget, passed in 2010, included reduced pension benefits for new employees and higher contributions for the rest.

“It’s like a frog being slowly boiled to death,” said Crane, who teaches at Stanford University near Palo Alto, Calif. “They’re not doing anything about the liabilities. In most states, they’re not being funded at all.”

Until accounting-rule changes in 2008 forced state and local governments to disclose other post-employment benefits besides pensions, most didn’t track the liability. There was no requirement to put money aside to pay for the promised coverage.

By 2009, when Moody’s cut Connecticut’s bond grade, they said the state owed more for retirees than its annual budget. The Nutmeg State, with a about 3.57 million people in 2010, had the second-highest unfunded liability per person, at $8,281, trailing only Alaska, with about 710,200 residents, at $16,742.

Passing the Buck

“There’s a bit of a reluctance to tackle the problem because it’s going to be someone else’s problem in a few years,” Gallagher Benefit’s Volk said. “Some think it’s not a real liability, that it’s an accounting thing.”

New Jersey estimates its unfunded liability for retiree health is more than twice what it owes for pensions, according to state figures. The Garden State has paid more to borrow from the municipal-bond market after three credit evaluators cut its ratings in part because of expanding pension and health-care obligations. Moody’s cited the growing cost of retiree benefits as a continuing fiscal challenge in reports last year.

The state’s liability for retiree benefits separate from pensions has more than quadrupled since 2008 to $13.5 billion in fiscal 2011. Its combined unfunded obligation, at $59.3 billion in fiscal 2010, includes coverage for retired teachers.

Christie said he initially sought to cut retiree health costs along with changes for current workers. Instead, he said he left out raising retiree expenses to smooth passage of other changes, under a “principled compromise” with Democrats who run the Legislature.

Seeking Lower Costs

“By offering retirees more choice, we could potentially lower costs,” Christie said last week in Trenton, the capital.

The law that resulted “illegally takes away benefits that school employees and others have already earned,” Barbara Keshishian, president of the New Jersey Education Association, said of the changes in a response posted last year on the union’s website.

During the 1990s, New Jersey’s Legislature cut workers’ required pension contributions at the same time it lowered the retirement age, without guaranteeing funds to cover the moves.

“We have structural problems in the pension system,” Senate President Stephen Sweeney, a West Deptford Democrat who sponsored the law that changed benefits last year, said in September. “We had to fix it.”

Setting Aside Funds

Massachusetts made progress toward covering its benefits costs by setting aside funds from a settlement with tobacco companies, according to CanagaRetna, of the Council of State Governments. The state plans to put away 10 percent of a $300 million payment to fund health-care costs for 10 years starting in 2013.

Apart from covering the liability, governments can also seek to curb benefits, at least for new employees, such as Schwarzenegger did. Unions and other employee groups have rallied legislative allies to fight benefits erosion, however.

Michigan was the only state that made significant changes in 2011 that will reduce its retiree health-care costs, said Ron Snell, who tracks such issues for the National Conference of State Legislatures, a nonprofit organization in Denver. Employees hired after Jan. 1 won’t be promised health benefits when they retire. Instead, the government and workers will contribute to a fund that retirees can use to pay for insurance.

Other states have increased worker contributions for benefits or copayments made by retirees, Snell said. Or they’re increasing the number of years workers must put in to qualify, CanagaRetna said.

States also may be delaying funding the benefit in the hope that the federal health-care overhaul will compel retirees to buy insurance until they are covered by Medicare, Volk said.

“There’s a bit of an attitude to see what happens under health-care reform,” CanagaRetna said. “We’re in a holding pattern.”

Underfunded retiree benefits may pose a bigger fiscal challenge to many states than pensions, since few have set aside money to help cover the cost, Crane said.

By contrast, state retirement plans have hundreds of billions of dollars for future pension payments, with a median value of about 75 percent of the assets needed to meet obligations, according to a Bloomberg Rankings analysis. The most poorly financed, Illinois, still held enough money in 2010 to cover about 45 percent of what it expects to owe.

Since health benefits often aren’t protected by law, states are under much less pressure to cover those future costs, said James Spiotto, a lawyer who heads Chapman & Cutler LLP’s special litigation, bankruptcy and workout group in Chicago. That also means it may be easier to reduce the obligations than pension expenses, he said.

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